UNIT 2 FINANCIAL SYSTEM AND

ITS COMPONENTS

25 MARKS 12 LECTUES
 WHAT IS FINANCE ?

 Finance refers to the provision of money as of when

required.
 It refers to all the monetary resources needed by
households, business units, firms and government.
 Individuals and households- require funds for daily
expenses and for capital goods and durable goods like
car, houses etc.
 Firms need funds for buying raw material, paying
wages, salaries , for machinery, capital goods etc.
 Government requires finance to meet its expenditure
on goods and services and also to finance its
infrastructure projects.
 Illustration of a Simple Financial System.

Income > expenditure Financial Expenditure> Income

Households, firms, Intermediaries Firms, government.
Surplus units, savers, Banks, Mutual funds, Borrowers, deficit
Ultimate lenders NBFCs etc spenders,
 Meaning of a Financial System

 Study of finance , money and credit , its nature and

functioning is organized into a system known as
financial system.
 It refers to a system which consists of a set of
institutional arrangement through which financial
surpluses from savers or surplus units or ultimate
lenders who are usually the household units get
transferred to borrowers or deficit spenders or
investors like firms , business units and government
 Institutional arrangements consist of :
 Financial Institutions like banks, mutual funds,
insurance companies, IFCI,
 Financial assets refer to the claim to the payment of
money in the future and periodic payment in the form of
interest, dividends. Egs shares, bonds, debentures, fixed
deposits etc.
 Financial Markets are centers which deal in various
financial assets like bills, shares, bonds, etc and the
participants on the demand and supply side are savers,
financial institutions, investors and borrowers who are
linked by contracts, laws and communication network.
Broad Structure/ Components of Indian
financial System

• Financial institutions
• Financial markets

Formal • Financial assets/

Instruments
• Financial Services.
• Financial Regulators.

• Money lenders.

Informal •
•
Local bankers
Traders.
• Landlords.
 Organised/ Formal financial system –financial
institutions, intermediaries, financial assets, financial
services and RBI, SEBI, Ministry of Finance.

 Unorganised /Informal financial system – individual

money lenders, landlords, chit funds, etc out of control
of RBI.
 Components of Indian financial system.
 There are five components of Financial System which
is discussed below:
 1. Financial Institutions:
 It ensures smooth working of the financial system by
making investors and borrowers meet.
 They mobilize the savings of investors either directly
or indirectly via financial markets by making use of
different financial instruments as well as in the
process using the services of numerous financial
services providers.

 They could be categorized into Regulatory,

Intermediaries, Non-intermediaries and Others.
 On the basis of Nature of their activities Financial
institutions can be classified as follows:

 a. Regulatory and Promotional institutions

 Financial Institutions, markets, participants are
regulated by RBI, Ministry of Finance, SEBI, Company
Law Board etc.
 Both RBI and SEBI administer, supervise, monitor -
Policies, procedures and guidelines.
 RBI – APEX of the financial institutions in India.
 SEBI- all financial markets under its control.
 b. Banking Institutions –Banks

 Banks are financial intermediaries that lend money

to borrowers to generate revenue and mobilise
savings of the public by accepting deposits . They are
typically regulated heavily, as they provide market
stability and consumer protection. Banks include:
 Commercial banks – public sector , private sector,
RRBs, Foreign banks
 Central bank- RBI
 Cooperative banks
 c. Non-Banking financial institutions

 They are also called Non- Banking Financial

Corporations.
 Non-banking financial companies (NBFCs) are
financial institutions that offer various banking
services but do not have a banking license.
 Generally, these institutions are not allowed to take
traditional demand deposits—readily available
funds, such as those in checking or savings
accounts—from the public.
 This limitation keeps them outside the scope of
conventional oversight from financial regulators.
 NBFCs can offer banking services such as loans and credit
facilities, currency exchange, retirement planning, money
markets, underwriting, and merger activities.
 NBFCs are financial institutions which can borrow from
public and lend or invest to companies or industries.

 Investment banks, mortgage lenders, money market funds,

insurance companies, hedge funds, private equity funds,
and P2P lenders are all examples of NBFCs.
 d. Mutual funds
 Mutual funds pool money from the investing public
and use that money to buy other securities, usually
stocks and bonds in the stock exchange.
 The value of the mutual fund company depends on the
performance of the securities it decides to buy.
 Investing in a share of a mutual fund is different from
investing in shares of stock.
 Unlike stock, mutual fund shares do not give its
holders any voting rights.
 A share of a mutual fund represents investments in
many different stocks (or other securities) instead of
just one holding. Eg. UTI, HDFC Long term MF, Aditya
Birla Mutual fund, etc.
 e. Insurance organisations

 Insurance companies also invest savings of policy

holders in mostly government securities in exchange
for life insurance cover or a higher sum of money at
a later stage on maturity.
 Provides a combination of savings with protection.
egs. LIC, ICICI life insurance, HDFC life, Birla Sunlife
etc.
These institutions also act like financial intermediaries
between savers and investors.
 Financial Markets.

 A place where funds from surplus units are

transferred to investor/ deficit units in the economy.
 It is a market for creation and exchange of financial
assets.
 Financial markets link savers and investors.
 Corporations, financial institutions, government,
individuals trade in financial products on this market
directly or indirectly.
Components of Financial Markets Based on Time
period or Maturity of Claims :

Financial Markets

Money Market Capital Market

Primary/ Secondary
New market/
issues stock
market exchange
 a. Money market

 A market where short term funds are borrowed and

lent.
 A market for dealing in monetary assets of short
term nature- 1 year or less.
 Liquid funds or highly liquid securities are traded in
money market.
 Major participants are : RBI and commercial banks,
government.
 Access to users of short term funds at reasonable
cost.
Components of money market

Call money
market

Repo Treasury
market bills

CD market CP market
 Capital Market

 It is a market for long term funds.

 It deals with long term claims, securities and stocks
with a maturity period of more than 1 year. The stock
market, government bond market, derivatives market
are examples of capital market.
 Capital market deals with long term debt and stock.
 Main participants are Mutual funds, Insurance
companies, FIIs, corporates and individuals.
 Flow of funds accounts of an Economy

 This theory was given by Prof Morris in 1952

 shows how funds flow between various sectors of
the economy.
 It shows the sources of all funds received by each
sector and uses to which funds are put by each
sector.
 Sources of funds for a sector can be from income or
borrowing.
 Uses of funds for a sector refers to spending or
lending.
 All changes in assets of a sector are recorded as Uses.
 Uses of funds show + sign if increase in assets and
 - sign if decrease in assets.
 Uses of funds refer to capital expenditure or real
investment spending like on machinery etc.

 All changes in liabilities are recorded as sources of funds.

 Sources of funds are increase in liabilities or net worth
or savings if positive
 And repayment of debt or dissaving if negative.

 Net worth is a sector’s total assets – total liabilities.

 In India flow of funds are organised into 2 parts
 Economic sectors
 Financial instruments.
 Flow of funds for the Indian economy provides
information on the following six sectors
 Households, private corporate sector, banking, other
financial institutions government and foreign sector
or rest of the world.
 These sectors participate in the financial activities
through borrowing and lending.
 If borrowing > lending ---sector is deficit sector
 reverse case --- sector is a surplus unit

 Financial assets and liabilities are classified under ten main

types of financial instruments
 Currency
 Deposits
 Investments
 Loans & advances
 Small savings
 Life insurance funds
 Provident funds, corporate deposits
 Trade debts
 Foreign claims and
 other claims
 Flow of funds is written as a MATRIX
 The matrix is prepared by studying the balance sheet
of various sectors at the beginning and at the end of
the financial period. This is the flow of funds during
that year.
 The net increase in assets is treated as USES of funds.
 Net increase in liabilities is treated as SOURCES of
funds .
 Flow of funds accounts includes inter sectoral flows
means a net flow of funds between sectors in the
economy and at two points of time.
 In India RBI publishes data on the flow of funds
accounts of the various sectors of the economy.
Role of financial system in economic
development
 The development of any country depends on the economic
growth the country achieves over a period of time.
 Economic growth deals about investment and production and
also the extent of Gross Domestic Product in a country.
 Only when this grows, the people will experience growth in the
form of improved standard of living, namely economic
development.

 Role of financial system in economic development of a country

 the roles of financial system in the economic
development of a country can be explained as follows.
 Savings-investment relationship
 To attain economic development, a country needs more
investment and production. This can happen only when
there is a facility for savings. As, such savings are
channelized to productive resources in the form of
investment.
 Here, the role of financial institutions is important, since
they induce the public to save by offering attractive
interest rates. These savings are channelized by lending
to various business concerns which are involved in
production and distribution.
 Financial systems help in growth of capital market
 Any business requires two types of capital namely, fixed capital and
working capital. Fixed capital is used for investment in fixed assets,
like plant and machinery. While working capital is used for the day-
to-day running of business. It is also used for purchase of raw
materials and converting them into finished products.

 Fixed capital is raised through capital market by the issue of

debentures and shares. Public and other financial institutions invest
in them in order to get a good return with minimized risks.
 For working capital, we have money market, where short-term loans
could be raised by the businessmen through the issue of various
credit instruments such as bills, promissory notes, etc.
 etc.
 Foreign exchange market enables exporters and
importers to receive and raise funds for settling
transactions. It also enables banks to borrow from
and lend to different types of customers in various
foreign currencies. The market also provides
opportunities for the banks to invest their short term
idle funds to earn profits. Even governments are
benefited as they can meet their foreign exchange
requirements through this market.
 Government Securities market
 Financial system enables the state and central
governments to raise both short-term and long-term
funds through the issue of bills and bonds which carry
attractive rates of interest along with tax concessions.
The budgetary gap is filled only with the help of
government securities market. Thus, the capital market,
money market along with foreign exchange market and
government securities market enable businessmen,
industrialists as well as governments to meet their credit
requirements. In this way, the development of the
economy is ensured by the financial system.
 Financial system helps in Infrastructure and Growth
 Economic development of any country depends on the
infrastructure facility available in the country. In the absence
of key industries like coal, power and oil, development of
other industries will be hampered. It is here that the financial
services play a crucial role by providing funds for the growth
of infrastructure industries. Private sector will find it difficult
to raise the huge capital needed for setting up infrastructure
industries.
 For a long time, infrastructure industries were started only by
the government in India. But now, with the policy of economic
liberalization, more private sector industries have come
forward to start infrastructure industry. The Development
Banks and the Merchant banks help in raising capital for
these industries.
 Financial system helps in development of Trade
 The financial system helps in the promotion of both domestic and
foreign trade.
 The financial institutions finance traders and the financial market
helps in discounting financial instruments such as bills.
 Foreign trade is promoted due to per-shipment and post-shipment
finance by commercial banks. They also issue Letter of Credit in
favor of the importer. Thus, the precious foreign exchange is earned
by the country because of the presence of financial system. The best
part of the financial system is that the seller or the buyer do not
meet each other and the documents are negotiated through the
bank. In this manner, the financial system not only helps the traders
but also various financial institutions.
 Some of the capital goods are sold through hire purchase and
installment system, both in the domestic and foreign trade. As a
result of all these, the growth of the country is speeded up.
 Employment Growth is boosted by financial system
 The presence of financial system will generate more employment
opportunities in the country. The money market which is a part of
financial system, provides working capital to the businessmen and
manufacturers due to which production increases, resulting in
generating more employment opportunities.

 With competition picking up in various sectors, the service sector

such as sales, marketing, advertisement, etc., also pick up, leading
to more employment opportunities.

 Various financial services such as leasing, factoring, merchant

banking, etc., will also generate more employment.
 The growth of trade in the country also induces employment
opportunities. Financing by Venture capital provides additional
opportunities for techno-based industries and employment.
 Venture Capital
 There are various reasons for lack of growth of venture
capital companies in India. The economic development
of a country will be rapid when more ventures are
promoted which require modern technology and venture
capital.
 Venture capital cannot be provided by individual
companies as it involves more risks. It is only through
financial system, more financial institutions will
contribute a part of their investable funds for the
promotion of new ventures. Thus, financial system
enables the creation of venture capital.
 Financial system’s role in Balanced regional
development
 Through the financial system, backward areas could be
developed by providing various concessions or sops. This
ensures a balanced development throughout the country
and this will mitigate political or any other kind of
disturbances in the country. It will also check migration
of rural population towards towns and cities.

 Role of financial system in attracting foreign

capital
 Financial system promotes capital market. A dynamic
capital market is capable of attracting funds both from
domestic and abroad. With more capital in the form FPI,
investment will expand and this will speed up the
economic development of a country.
 Financial system’s role in Economic Integration
 Financial systems of different countries are capable
of promoting economic integration. This means that
in all those countries, there will be common
economic policies, such as common investment,
trade, commerce, commercial law, employment
legislation, old age pension, transport co-ordination,
etc. We have a standing example of European
Common Market which has gone to the extent of
creating a common currency, representing several
countries in Western Europ
 Financial system helps in Uniform interest rates
 The financial system is capable of bringing an uniform
interest rate throughout the country by which there will be
balanced movement of funds between centres which will
ensure availability of capital for all kinds of industries.

 Financial system role in Electronic development:

 Due to the development of technology and the introduction
of computers in the financial system, the transactions have
increased manifold bringing in changes for the all round
development of the country. Mobile banking apps, internet
banking, electronic share trading, bank fund transfers
have saved time and transaction cost.
Overview of the Indian Financial System
 Overview of the Indian Financial System

 Introduction
 At the time of independence – 1947
 There was no strong financial institutional
mechanism in the economy
 Industry had no access to capital.
 Capital markets were under developed.
 Unorganised private sector played main role in
providing liquidity.
 After independence – government adopted a planned
and mixed economic system for growth.

 Government created many financial institutions under

the public sector for supplying funds for industrial and
agricultural development.
Following are the important developments - in the Indian financial systems:

 1. Nationalization of financial institutions :

 RBI set up in 1935.

 Nationalized in 1949.
 LIC came into existence in 1956.
 Another important development was nationalization
of 14 major commercial banks in 1969 and 6 more in
1980.
 Another landmark was nationalization of General
Insurance corporation in 1972.
 Functionally, banks catered to the needs of the
organised industrial and trading sectors.
 The primary sector consisting of 'agriculture, forestry
and fishing', which formed more than 50 per cent of
GDP during 1950s to depend largely on self financing
and on sources outside the commercial banks like
money lenders and indigenous bankers.
 It is against this backdrop that the process of financial
development was given impetus with the adoption of
the policy of nationalisation of banks in 1969.
 2. Establishment of Development banks

 Another landmark in the history of development of

Indian financial system is the new financial
institutions to supply long term funds to industry.
 after a RBI feasibility study, the first development
institution was set up in 1948.
 Industrial Finance Corporation of India(IFCI).
 In 1951 , parliament passed the State Financial
Corporation Act. Under this state governments could
set up financial corporations for their own regions.
 ICICI- Industrial Credit and Investment Corporation of
India (ICICI) was set up in 1955 with the financial support
of Government and World Bank.
 .UTI – Unit Trust of India was set up in 1964 as a public
sector mutual fund to collect savings of the middle class
people in India and mobilise it for investment in the capital
market securities.
 Also IDBI- Industrial Development Bank of India, was set
up on 1st July 1964 as a wholly owned subsidiary of RBI.
 In 1976 IDBI was delinked from RBI and become an
independent institution and started coordinating the
activities of other development finance institutions.

 In 1971 IDBI and LIC jointly set up IRCI- Industrial
Reconstruction Corporation of India to rehabilitate
sick industrial units.
 IRCI was converted into a statutory corporation in
1976 and renamed IRBI- industrial Reconstruction
Bank of India. today it is known as IIBI- Industrial
Investment Bank of India.
 In 1982 – Export Import (EXIM) Bank was set up to
provide financial assistance to Indian exporters and
importers.
 In April 1990 the SIDBI - Small Industries
Development Bank of India of India was set up as a
wholly owned subsidiary of IDBI. It is the main
agency to give finance to the MSME sector
 3. Establishment of Institution for Agricultural
Development
 In 1963 – Agricultural Refinance and Development
Corporation (ARDC) to provide refinance support to
banks to finance major development projects , minor
irrigation , farm mechanization etc.
 In order to meet the credit needs of agriculture and
rural sector NABARD – National Bank for
Agriculture and Rural development was set up in 1982.
 NABARD – provides refinance and financial
assistance to banks which help agriculture and allied
activities. Also provides micro finance to Self Help
Groups


 4. National Housing Bank

 National Housing Bank was set up in 1988 to

mobilise resources for the housing sector and to
promote housing finance institutions.
 5. Stock Holding Corporation of India
 In 1987 SHCI was set up for quick share transfer
facilities, clearing services, support services etc to
investors .
 To strengthen stock markets and capital markets in
India.
 6. Mutual Funds and Venture capital funds
 IDBI venture capital funds
 Technology Development.

 New trends are seen with FDI and FPI.